By: Kevin Braun and Greg Norton, Morgan Lewis
Guarantors’ waiver of defenses to enforcement under guaranty of a lease was upheld, as Guarantor failed to show that the lease was a security interest (as to which Article 9 of the UCC would apply, and under which defenses such as the requirement of good faith and fair dealing cannot be waived) instead of a true lease (governed by Article 2A of the UCC, under which such defenses could be waived). Huntington Technology Finance., Inc. v. Neff, 2020 WL 1430092 (D. Conn. Mar. 24, 2020).
Huntington Technology Finance (the “Lessor”) entered into a lease agreement involving the individuals Garret Alan Neff, John Mark Schmid, and David Karl Schmid (collectively, the “Guarantors”) and their LLC (the “Lessee”) for an electronic sign to which the Lessee would pursue advertising revenue derived from ads displayed on the sign. The lease had a “Three Year Renewal with End-of-Term Ownership” option. In the option, the Lessee would make monthly rent payments for an additional 3 years and then could purchase the sign for one dollar, regardless of its value.
The Guarantors signed a guaranty that guaranteed the payments under the lease as well as performance of all other agreements in favor of the Lessor in connection with lease. The guaranty was “absolute and unconditional [and] not to be affected, diminished, or released under any conditions”, and also provided that the Guarantors’ “defense to enforcement of the guaranty were waived.”
The Lessee, and Guarantors, failed to make payments and the Lessor filed suit for breach of contract.
The Lessor argued that all 3 factors to establish a prima facie case for recovery under a guaranty have been met: 1) they are owed a debt from a third party; 2) the Guarantors made a guaranty of payment of the debt; and 3) the debt has neither been paid by the third party or the Guarantors. The Guarantors did not contest these facts; they however argued, among other things, that the lease agreement is not a true leasing arrangement and is rather a security interest in the Lessor’s favor and therefore should be governed by Article 9 of the UCC which would not allow for the Guarantors to waive all defenses to enforcement of the guaranty. The Lessor moved for summary judgement and the Guarantors moved for partial summary judgement.
The court stated that under New York law, there is a Bright Line Test to determine whether a lease constitutes a sale of property with a security interest rather than a true lease:
“(a) Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if the consideration the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee, and:
(i) the original term of the lease is equal to or greater than the remaining economic life of the goods,
(ii) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods,
(iii) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or
(iv) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.”
If the Bright Line Test is satisfied, then the lease is a security interest as a matter of law. If the Bright Line Test is not satisfied, specific facts of the lease transaction will determine whether it is a true lease or a security interest, with the key fact being “whether the lessor retained a reversionary interest [in the property].”
The Guarantors believed that the test was satisfied by the fact that 1) the Lessee could not terminate the lease agreement and 2) the Lessee had the option to buy the Lessor’s interest in the sign for one dollar at the end of the renewal term. The court disagreed, reasoning that the lease transaction was a lease because it is not certain that the Lessee would actually exercise the renewal option. The Lessee had stopped making payments prior to any renewal taking place, so the transaction must be analyzed by looking at the “base term” and residual value at that point. A later endorsement to the lease did in fact allow the Lessee to purchase the sign at the end of their original base term lease, prior to any renewal, however it was for a price of more than one million dollars.
With no evidence presented by the Guarantors of what the true residual value of the sign may have been, the court reasoned that one million dollars is a strong indication that the Lessor was retaining some residual interest in the sign and held that the Guarantors failed to carry the burden that the lease was a mere security interest. Therefore the court held Article 2A of the UCC applies, not Article 9, allowing for the waiver of all defenses to the guaranty to be valid.
Additionally, the court noted that even if the Lease were considered a mere security interest, New York courts have consistently allowed for “absolute and unconditional” guaranties to be enforceable, even in extreme cases such as fraud. Here the parties contracted around the UCC’s provisions, and if the Guarantors were able to escape their obligations as defined in the guaranty, to which the parties agreed there would be “no affirmative defense”, they would essentially be participating in a fraud of their own by misrepresenting their true intentions under their guaranty. Therefore, the court granted the Lessor’s motion for summary judgement and denied the Guarantor’s motion for partial summary judgement.